Assessing the Energy-Efficiency Gap

Global energy consumption is on a path to grow 30-50 percent over the next 25 years, bringing with it, in many countries, increased local air pollution, greenhouse gas (GHG) emissions, and oil consumption, as well as higher energy prices.  Energy-efficient technologies offer considerable promise for reducing the costs and environmental damages associated with energy use, but these technologies appear not to be used by consumers and businesses to the degree that would apparently be justified, even on the basis of their own (private) financial net benefits.

For some thirty years, there have been discussions and debates about this phenomenon among researchers and others in academia, government, non-profits, and private industry, typically couched in terms of potential explanations of the so-called “energy efficiency gap” or “energy paradox.”

Thinking About the Energy-Efficiency Gap

I wrote about this some two years ago at this blog ().  I  noted then that Professor Richard Newell of Duke University and I had just launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on potential explanations of the energy paradox and identify key gaps in knowledge. We subsequently conducted a comprehensive review and assessment of social-science research on the adoption of energy-efficient technologies.

We worked with leading social scientists — including scholars from economics, psychology, and other disciplines, at a workshop held at Harvard — to examine the various possible explanations of the energy paradox and thereby to help identify the frontiers of knowledge on the diffusion of energy-efficient technologies.  As materials became available, we posted them at the project’s Harvard website and the project’s Duke website.

Releasing a New Monograph

I’m pleased to inform readers of this blog that we have now released a major monograph, Assessing the Energy Efficiency Gap, co-authored with Todd Gerarden, a Harvard Ph.D. student in Public Policy and a Pre-Doctoral Fellow of the Harvard Environmental Economics Program (HEEP).  The monograph draws in part from the research workshop held at Harvard (in October 2013), in which most of the U.S.-based scholars (primarily, but not exclusively, economists) then conducting research on the energy-efficiency gap participated. HEEP co-sponsored a second such research workshop with the Centre for European Economic Research (ZEW) in Mannheim, Germany in March 2014, where European economists explored the same topic. Closely-related research was presented by panelists at the annual conference of the Allied Social Science Association in January 2015.

In the new monograph, Gerarden, Newell, and I examine both the “energy paradox,” the apparent reality that some energy-efficiency technologies that would pay off for adopters are nevertheless not adopted, and the broader phenomenon we characterize as the “energy-efficiency gap,” the apparent reality that some energy-efficiency technologies that would be socially efficient are not adopted. The contrast is between private and social optimality, which ultimately has important implications for the role of various policies, as well as their expected net benefits.

Four Key Questions

We begin by decomposing cost-minimizing energy-efficiency decisions into their fundamental elements, which allows us to identify four major questions, the answers to which are germane to sorting out the causes (and reality or lack thereof) of the paradox and gap.

First, we ask whether the energy efficiency and associated pricing of products on the market are economically efficient. To answer this question, we examine the variety of energy-efficient products on the market, their energy-efficiency levels, and their pricing. Although the theory is clear, empirical evidence is—in general—quite limited. More data that could facilitate potential future empirical research are becoming available, although firm-level data are much less plentiful than data on consumers. We do not see this area as meriting high priority for future research, however, with the exception of research that evaluates the effectiveness and efficiency of existing energy-efficiency information policies and examines options for improving these policies.

Second, we ask whether energy operating costs are inefficiently priced and/or understood. Even if consumers make privately optimal decisions, energy-saving technology may diffuse more slowly than the socially optimal rate, because of negative externalities. So, even if the energy paradox is not present, the energy-efficiency gap may be. As in the first realm, the theoretical arguments are strong. Empirical evidence is considerable, and in many cases data are likely to be available for additional research. Existing policies appear not to be sufficient from an economic perspective, suggesting that further research is warranted. Indeed, we ascribe high priority to the pursuit of research in this realm.

Third, we ask whether product choices are cost-minimizing in present-value terms, or whether various market failures and/or behavioral phenomena inhibit such cost-minimization. We find that the empirical evidence ranges from strong (split incentives/agency issues and inattention/salience phenomena) to moderate (heuristic decision-making/bounded rationality, systematic risk, and option value) to weak (learning-by-using, loss aversion, myopia, and capital market failures). Importantly, here, as elsewhere in our review, the bulk of previous work has focused on the residential sector and much less attention has been given to the commercial and industrial sectors. Some areas merit priority for future research, such as empirical analysis of split incentives/agency issues in areas where efficiency standards are not present, and much more work can be done in the behavioral realm.

Fourth, we ask whether other unobserved costs may inhibit energy-efficient decisions. We find that the empirical evidence is generally sound, and that data needed for more research are available. We assign a relatively high priority to future research, particularly to aid understanding of consumer demand for product attributes that are correlated with energy efficiency, thereby informing policy and product development decisions.

Three Categories of Potential Explanations of the Gap

Finally, we ask what these findings have to say about the three categories of explanations (reviewed in detail in my 2013 essay at this blog) for the apparent underinvestment in energy-efficient technologies relative to the predictions of some engineering and economic models: (1) market failures, (2) behavioral effects, and (3) modeling flaws.  In brief, potential market-failure explanations include information problems, energy market failures, capital market failures, and innovation market failures. Potential behavioral explanations include inattentiveness and salience, myopia and short sightedness, bounded rationality and heuristic decision-making, prospect theory and reference-point phenomena, and systematically biased beliefs. Finally, potential modeling flaws include unobserved or understated costs of adoption; ignored product attributes; heterogeneity in benefits and costs of adoption across potential adopters; use of incorrect discount rates; and uncertainty, irreversibility, and option value.

It turns out that all three categories of explanations are theoretically sound and that limited empirical evidence exists for every category as well, although the empirical research is by no means consistently strong across all of the specific explanations.  The validity of each of these explanations—and the degree to which each contributes to the energy-efficiency gap—are relevant for crafting sensible policies, so Gerarden, Newell, and I hope that our new monograph can help inform both future research and policy.  Given the many energy-efficiency policies and programs that are already in place, high priority should be given to research that evaluates the effectiveness, cost-effectiveness, and overall economic efficiency of existing energy-efficiency policies, as well as options for their improvement.


Thinking About the Energy-Efficiency Gap

Adoption of energy-efficient technologies could reap both private and social rewards, in the form of economic, environmental, and other social benefits from reduced energy consumption. Social benefits include improvements in air quality, reduced greenhouse-gas emissions, and increased energy security. In response, governments around the world have adopted policies to increase energy efficiency.  Still, there is a broadly held view that various barriers to the adoption of energy-efficient technologies have prevented the realization of a substantial portion of these benefits.

For some thirty years, there have been discussions and debates among researchers and others in academia, government, non-profits, and private industry regarding the so-called “energy efficiency gap” (or “energy paradox”) — the apparent reality that many energy-efficiency technologies are not adopted even when it makes sense for consumers and businesses to do so, based on their private costs and benefits. That is, decision makers appear to “under-invest” in energy-efficient technologies, relative to the predictions of some engineering and economic models.

What causes this gap?  The answer to that question could presumably help inform the development of better public policy in this realm.

Possible Explanations for the Energy-Efficiency Gap

Potential explanations for the energy efficiency gap tend to fall into three broad categories: (1) market failures, such as lack of information or misplaced incentives; (2) behavioral effects, such as inattentiveness to future energy savings when purchasing energy-consuming products; and (3) modeling flaws, such as assumptions that understate the costs or overstate the benefits of energy efficiency.  In this essay, I simply want to outline the types of hypothetical explanations of the gap that have been posited within these three broad categories.

Market-Failure Explanations

First, various Innovation Market Failures have been posited, including:  research and development (R&D) and learning-by-doing spillovers; inefficient product quality and differentiation due to market power; and inefficient introduction of new products due to consumer taste spillovers (for example, consumers becoming comfortable with a new technology).

Second, another set of potential market-failure explanations for the gap may be characterized as Information Problems.  These include:  lack of information on the part of consumers (learning-by-using or so-called experience goods; energy prices; energy consumption of products; and available substitutes); asymmetric information (the “lemons problem”); and split incentives and principal-agent issues (such as the frequently-discussed renter/owner dichotomy).

Third, there are Capital Market Failures and Liquidity Constraints, which may be a particularly significant issue in developing-country contexts.

Fourth, there are Energy Market Failures, including various externalities (environmental, energy security, congestion, and accident risk), as well as average-cost pricing of electricity.

Behavioral Explanations

The rise of behavioral economics has brought to the fore another well-defined set of potential explanations of the energy efficiency gap.  A variety of alternative taxonomies could be employed to separate these explanations, but one such taxonomy would categorize the explanations as:

Model and Measurement Explanations

The third category of possible explanations of the energy efficiency gap consists essentially of a set of reasons why observed levels of diffusion of energy-efficiency technologies may actually be privately optimal.

First, there is the possibility of unobserved or understated adoption costs, including unaccounted for product characteristics.

Second, there may be overstated benefits of adoption, due to inferior project execution relative to assumptions, and/or poor policy design.

Third, an incorrect discount rate may be employed in an analysis, when the correct consumer and firm discount rates should vary with:

  • opportunity cost of and access to capital
  • income
  • buying versus retrofitting equipment
  • systematic risk
  • option value (see below)

Fourth, there is frequently heterogeneity across end users in the benefits and costs of employing energy-efficiency technologies, so that what is privately optimal on average will not be privately optimal for all.  This can refer either to static (cross-sectional) heterogeneity or to dynamic (intertemporal) heterogeneity, that is, technology improvements over time, which raises two possibilities:  the reality of some potential adopters being short of the frontier, and the presence of option value to waiting.

Fifth and finally, there is the possibility of uncertainty (real, not informational, as above), irreversibility, and option value.  This could be due to uncertainty regarding future energy prices, or can be linked with option value that arises for delaying investments that have only minimal if any salvage value.

Public Policy and Next Steps

Determining the validity of each of these possible explanations — and the degree to which each contributes to the energy efficiency gap — are crucial steps in crafting the most appropriate public policy responses.

To inform future research and policy, Professor Richard Newell of Duke University and I have launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on these potential explanations of the energy paradox and identify key gaps in knowledge.  We are conducting a comprehensive review and assessment of published and ongoing social-science research on the adoption of energy-efficient technologies, including scholarly literature, industry case studies, reports from national and sub-national governments, and, to the extent possible, consulting reports evaluating specific programs.

We are working with leading social scientists — including scholars from economics, psychology, and other disciplines — to examine the various possible explanations of the energy paradox and thereby to help identify the frontiers of knowledge on the diffusion of energy-efficient technologies.  We hope the products of this initiative will help decision makers in industry and government better understand the energy efficiency gap, and will thereby contribute to decisions that maximize the potential economic, environmental, and other social benefits associated with optimal adoption of energy-efficient technologies.  As materials become available, we will post them at the project’s Harvard website and the project’s Duke website, and I will alert readers of this blog.  In the meantime, please stay tuned.


Renewable Energy Standards: Less Effective, More Costly, but Politically Preferred to Cap-and-Trade?

The new Congress is beginning to consider various alternative energy and climate policies in the wake of last year’s collapse in the U.S. Senate of consideration of a meaningful, economy-wide CO2 cap-and-trade scheme.  Among the options receiving attention are various types of renewable portfolio standards, also known as renewable electricity standards or clean energy standards, depending upon their specific design.  These approaches, which focus exclusively on one sector of the economy, would be less effective than a comprehensive cap-and-trade approach, would be more costly per unit of what is achieved, and yet – ironically – appear to be much more attractive to some politicians who strenuously opposed cap-and-trade.

True enough, these standards can be designed in a variety of ways, some of which are better and some of which are worse.  But the better their design (as a CO2 reducing policy), the closer they come to the much-demonized cap-and-trade approach.

In an op-ed which appeared on November 24th in The Huffington Post (click here for link to the original op-ed), Richard Schmalensee and I reflected on this irony.  Rather than summarize (or expand on) our op-ed, I simply re-produce it below as it was published by The Huffington Post, with some hyperlinks added for interested readers.

For anyone who is not familiar with Dick Schmalensee, please note that he is the Howard W. Johnson Professor of Economics and Management at MIT, where he served as the Dean of the Sloan School of Management from 1998 to 2007.  Also, he served as a Member of the President’s Council of Economic Advisers in the George H. W. Bush administration from 1989 to 1991.  By the way, in a previous blog post, I featured a different op-ed that Dick and I wrote in The Boston Globe in July of last year (“Beware of Scorched-Earth Strategies in Climate Debates”).

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Renewable Irony

by Richard Schmalensee and Robert Stavins

The Huffington Post, November 24, 2010

One day after the election, the White House press secretary Robert Gibbs said that a national renewable electricity standard could be an area of bipartisan energy cooperation, after President Obama had said cap-and-trade was not the only way “to skin the cat.” It is ironic that while cap-and-trade — a sensible approach to reducing carbon dioxide emissions linked with climate change — is dead and buried in the Senate, considerable support has emerged for an approach that would be both less effective and more costly. A national renewable electricity standard would mandate that a given share of an electric company’s production come from renewable sources (most likely wind power), or, in the case of a “clean energy standard,” from an expanded list including nuclear and hydroelectric power.

One irony is that cap-and-trade is a market-based approach to environmental protection, which harnesses the power of the marketplace to reduce costs imposed on business and consumers, an approach championed by Republican presidents beginning with Ronald Reagan. Within its narrow domain, the renewable standard approach, which involves nationwide trading of renewable energy credits, is also market-based. Whereas cap-and-trade would raise the cost of fossil fuel, as its opponents have stressed so effectively, renewable standards would raise the cost of electricity, which its supporters seem reluctant to admit.  If renewables really were cheaper, even with Federal subsidies, it wouldn’t take regulation to get utilities to use them.

A second source of irony is that renewable or clean electricity standards are a very expensive way to reduce carbon dioxide (CO2) emissions — much more expensive than cap-and-trade. These standards would only affect electricity, thereby omitting about 60 percent of U.S. CO2 emissions. And even then, the standards would provide limited incentives to substitute away from coal, the most carbon-intensive way to generate electricity. Even more problematic, renewable/clean electricity standards would provide absolutely no incentives to reduce CO2 emissions from heating buildings, running industrial processes, or transporting people and goods. And unlike cap-and-trade, which would also affect oil consumption, the electricity standards would make no contribution to energy security. Only a very tiny fraction of U.S. oil consumption is used to generate electricity.

Increasing renewable electricity generation is no more than a means to an end for one part of the economy. Cap-and-trade keeps our eyes on the prize: moving the entire economy toward climate-friendly energy generation and use.

Those who believe that renewable electricity standards would create a huge number of green jobs have forgotten the lesson of Detroit: a large domestic market does not guarantee a healthy domestic industry. At the end of 2008, for instance, the U.S. led the world in installed wind generation capacity, but half of new installations that year were accounted for by imports. And a recent Lawrence Berkeley Laboratory study of the impacts of the economic stimulus package incentives for renewable electricity investments estimated that about 40 percent of the (gross) jobs created by new wind-energy investments were outside the United States, where many wind turbines are manufactured.

A sounder approach, for those concerned about green jobs, would focus on the long-term determinants of economic growth, such as technological innovation. That’s where cap-and-trade — which creates broad-based incentives for technology innovation — holds another edge over renewable electricity standards.

It is often argued that if cap-and-trade is dead, enacting renewable or clean electricity standards is better than doing nothing at all about climate change.  While that argument has some merit, since the risks of doing nothing are substantial, there is a real danger that enacting these standards will create the illusion that we have done something serious to address climate change.  Worse yet, it could create a favored set of businesses that will oppose future adoption of more efficient, serious, broad-based policies — like cap-and-trade.

If a national renewable electricity standard is nonetheless inevitable, it should not impose excess costs on businesses or consumers.  It should pre-empt state renewable portfolio standards, since with a national standard in place, states’ programs simply impose extra costs on their citizens without affecting national use of renewables at all. And any national program should allow unlimited banking to encourage early investments. No environmental or economic purpose is served by limiting banking to two years, as current Senate legislation would do.

Carbon cap-and-trade has been killed in the Senate, presumably because of its costs.  Renewable electricity standards or clean energy standards would accomplish considerably less and would impose much higher costs per ton of emissions reduction than cap-and-trade would.  This does not sound like a step forward.

Richard Schmalensee is the Howard W. Johnson Professor of Economics and Management at the Massachusetts Institute of Technology; Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School.